Monday, January 13, 2014

As I noted two and a half years ago, the best way to get the federal budget back in balance was to cut the growth of spending and pursue policies that helped the economy to grow. I'm not sure Washington has done much to pursue the latter point, but Congress has exceeded all expectations on the former: federal spending has not grown at all since the recovery started in June 2009.

The most important thing about all this progress on the deficit is that it was totally unexpected. Those are the kinds of things that move markets. Federal spending in calendar year 2013 was only slightly above its post-War average of 19.1% of GDP, by my calculations. Federal revenues were only slightly below their post-War average of 17.2% of GDP. Nobody on earth expected this to happen back in mid-2009. This achievement was brought about largely by a combination of a) no growth in spending and b) the recovery, which boosted the tax base. (Message to Obama: the economy can grow best when government does the least to "stimulate" it with transfer payments and make-work projects.)

The chart above makes it clear: spending has not increased since the recovery started (and it has even declined in the past few years), while tax revenues have surged—and most of the surge happened well before tax rates went up a year ago. I credit a gridlocked Congress and the economic recovery for this tremendous and welcome achievement.

As a result, the budget deficit has plunged from a high of 10.2% of GDP to now only 3.3%. This is less than the budget deficit during most of the Reagan years, and does not present any problem going forward. The deficit has ceased to become a serious problem almost overnight. That's great news, because it means that the argument for higher taxes has all but evaporated, and because a smaller government has resulted in a huge reduction in expected future tax burdens. This is very bullish for growth going forward.

Keynesians would have told us four years ago that freezing government spending would almost certainly doom the economy to another recession and higher unemployment, but they would have been dead wrong. As the chart above shows, the huge decline in the budget deficit has coincided (not necessarily caused, mind you) with a huge decline in the unemployment rate. The latter has a lot to do with the decline in the labor force participation rate, but at the very least it should be clear that this massive "fiscal contraction" (as the Keynesians would term it) has not damaged the economy one whit. Sure, it may have slowed the recovery, but it did not kill the economy. On the contrary, the economy has managed over four years of an ongoing and meaningful recovery. Maybe, just maybe, it's the case that getting government out of the way (by shrinking spending relative to the economy) allows the private sector more room to breathe, and that in turn is what generates growth. I raised this possibility almost exactly three years ago.

"The company estimated that the government spent $101 billion last year on management and technology consulting. Around 60% of that was tied to the Department of Defense. The rest was spent by civil agencies. Just think about that number for a minute."

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